The riddle of the deficit (or deficits for Dummies)

It seems that you’re still having a bit if a struggle to understand what a budget deficit is, and what it does.

Let me try and explain.

Imagine that I’m the ‘Government’ and you are the ‘Private Sector’. I give you a bar of chocolate. Now, I (the ‘Government’) am in deficit to the tune of one bar of chocolate… but you (the ‘Private Sector’) are in surplus to the sum of one bar of chocolate.

Are you with me so far? The government sector and the private sector or non-governmental sector, are opposite sides of the same coin. A deficit for the government means a gain in the private sector and vice versa. (The private sector means everything in the domestic economy, which is not government – I’m leaving out exports/imports to keep it simple).

One way or another, Government spending all goes into the private sector … payments for the NHS, Education, the military, unemployment benefits, working tax credits, child benefit, the Police, the judiciary, pensions, motorways, new infrastructure, grant to local governments and much more, are each paid for out of government spending.

OK? So government doesn’t just spend, it also taxes.

So I’ll be the ‘Government’ again, and I’ll give you (the ‘Private Sector’) a bar of chocolate and then take back half of it, as a tax. Now both the ‘Government’ and the ‘Private sector’ have half a bar of chocolate each but the government has a budget deficit of half a bar of chocolate whilst the private sector is increased by half a bar of chocolate.

With that extra half a bar of chocolate you have a lot of options. For example, you could eat it (i.e. consume goods and keep someone in a job replacing them); give it to someone to mend your bike (i.e. create employment); put it in the cupboard for another day (i.e. save) or repay your friend the chocolate you owe him (i.e. pay off debts).

The way to work out if the government has a budget deficit, a balanced budget or a surplus is simply to subtract the total amount collected in tax from the total amount that government spends. At the moment, the UK has a budget deficit, which means that the amount spent is greater than the amount of tax collected.

However, George Osborne says this is absolutely ‘frightful’ and that under his new policies, the UK will be in surplus by 2020 (!)

So what does a surplus mean for those of us in the private or non-governmental sector?

Well, if I pretend to be the ‘Government’ again, and I give you (the ‘Private Sector’) a bar of chocolate and then take it all back again … the budget will be balanced. Government spent a bar of chocolate and collected a bar back again… but you in the private sector have nothing more than you had before the ‘Government’ started spending! (How great does a balanced budget sound now?)

To be in surplus, I as the ‘Government’ would give you a bar of chocolate and then demand a bar and a half of chocolate back from you (the ‘private sector’). Now you have the problem of how you are going to get me that additional half a bar of chocolate? Maybe you have some saved bars of chocolate which you can use for a year or two but eventually you may have to go into debt or even sell your house to give me, the Government, that extra half bar of chocolate!

As J.D. Alt writes in his excellent US post:

If [government] runs a “budget surplus” for long, the Private Sector will either have to diminish its economic activity in general (go into recession)—or plunge hopelessly into debt (borrowing bank money it can’t repay, possibly causing a banking crisis)—or both.

Instead of creating jobs by spending, paying off debts or saving, a surplus budget eventually leads to redundancies, greater household indebtedness and greater precariousness of the workforce.

Obvious questions are raised by this simple story, like where did I (the ‘Government’) get the money to buy the chocolate in the first place? Answer: I created it – that’s what Governments do if they’re the sovereign issuer of its own currency! This is an incontrovertible fact – only the UK government can create Pounds Sterling – anyone else is committing the criminal act of counterfeiting.

If sovereign governments can create as much money as they want, why does the UK government need to collect tax to fund public spending? Answer: It doesn’t – there are many essential reasons* for the government to collect tax but taxes do not pay for anything.

Think about it, if government kept on spending into the private sector without having a means of also draining the economy, we would have rampant inflation. (Literally, if it was all in bars of chocolate!) So tax is one of the means of keeping the amount government spends into the private sector equivalent to the number of goods and services available for people to buy… thus preventing price inflation.

That is probably enough for now. I would recommend this and this for more information but please don’t hesitate to contact me if you need further explanation as to how the economy really operates.

Kind regards

Yours sincerely

Syzygysue

* Tax is important for lots of reasons including giving value to the currency but it does not fund government spending.

PS. We’re constantly told that the deficit means that future generations will have to pay off our debts. This is simply rubbish. Which would your children really benefit** from? Half a chocolate bar (deficit budget), no chocolate bar (a balanced budget) or increased household debt and a potential recession (a surplus budget)? It would be no contest in my family!

15 thoughts on “The riddle of the deficit (or deficits for Dummies)”

🙂 Sue, that is brilliant! Made me chuckle. I am not economist – though the philosphy that money should work for people and not banks is instinctive for any socialist. But so many economic papers are boring, and the jargon blinds the truth. Comes down in the end – Do people work for the economy (and therefore maintaining the status quo), or does the economy work for what people need? In other words, what really, really matters. Money or People? Please tell Mr Osborne. Perhaps he likes chocolate? 🙂

The cost and limit to spending is real resources.
Government spends from its buffer by crediting bank accounts and then backfills the buffer. The DMO is constantly reshuffling gilts for reserves to backfill the buffer?
Question: Why? The buffer is infinite in a country that issues its own currency?
“Instead of

‘what are you going to cut to fund programme X/tax cut Y[1]’

you can have:

‘fund programme X/tax cut Y[1], which will either pay for itself by expansion in the real economy (in which case inflation will stay steady and there will be no compensatory tax/interest rate[1] rises), or it won’t (in which case this tax/interest rate[1] will change).’

(1 – delete as applicable depending on political prejudice/religious belief[1]).

In other words the policy options switch from ‘pre-fund’ to ‘post-fund as required to maintain stable prices’. Taxation is no longer linked rigidly to the amount of government spending, but to the combination of government spending, net private sector nominal saving and the real expansion of the economy.”